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When it comes to investment strategy for self managed super funds or self invested personal pension plans, unless you are a retiree with lots of time on your hands or a very competent stock picker, index/tracker funds or actively managed funds are probably going to play some role.

In making the choice for your SMSF strategy between passive trackers and actively managed funds there are two commonly cited reasons as to why you should choose passive versus actively managed funds:

1. Cost– and specifically the impact of management costs over the long period of a superannuation fund investment. According to Rainmaker’s most recent survey, cited in the Australian, “the fee varies according to what you buy: workplace super funds average 1.41 per cent, personal super funds average 2.03 per cent and retirement funds average 1.86 per cent. ‘Out of that, the weighted industry average is 1.36 per cent,’ says Andrew Keevers, Rainmaker’s associate director of research.”

Of course this includes ‘unavoidable’ costs like compliance costs but it also includes perhaps more avoidable costs like trailing sales commissions paid to advisors. It is not an entirely fair comparison (simply because it does not include super-specific running costs) but the management expenses of something like the iShares IJP tracker runs at .5% (and that’s not the cheapest tracker around).

1% or so difference between an actively managed fund and a tracker doesn’t sound like much on the face of it but the impact of just 1% over a longer period can be quite high. For example, from memory the average SMSF in Australia is around $250,000. Assume two SMSFs, one with passive trackers, one with actively managed funds (with slightly higher expenses) are both held for 15 years starting with a balance of $100,000 (to make it simple I have assumed no new contributions). Assume the same return of 6% p.a. (see point 2 below about returns) but a 1% higher management fee in the actively managed fund so the net return on the passively managed SMSF (after expenses) is 5% and the net return on the actively managed SMSF (after expenses) is 4%:

So a 1% difference in returns compounded over 15 years leads to a 20% difference in the value of the fund on retirement … now imagine the impact with new contributions every year plus longer timelines given increasing life expectancy…

2. Returns– tend to be lower in most managed funds than passive funds. Whilst individual managers may have periods of outperformance this tends not to last. It is sometimes thought that active fund managers may perform better in bear markets, but even this doesn’t look like it is true:

“Lipper Inc. studied active managers’ performances in bear markets (defined as a drop of 10% or more in the equity markets). Lipper found that active managers underperformed the S&P 500 Index in the six market corrections occurring between August 31, 1978, and October 11, 1990. For example, the average loss for the S&P 500 Index in these episodes was 15.1%, compared with a 17.0% average loss for large-cap growth funds.” [Source Vanguard]

Both these points are commonly cited when it comes to comparing active management and tracker funds. However the advantage that you do not see mentioned so much relates to entry and exits.

Whether you are picking stocks yourself, or paying an active manager to do it for you, it often seems like the hard part is knowing when to sell … knowing when to buy is much easier.

For instance, if you are a value investor (you tend to buy stocks that you think are undervalued on say price/sales ratios or PE or whatever) broadly speaking one of two things is likely to happen, you were right (it was undervalued and the price goes up), or you were wrong (it was actually overvalued because it had a load of debt that it is having trouble refinancing and that wasn’t captured in the ratios you used).

Assuming you picked well at what point do you sell? When it’s priced at the correct ratio? What if things have changed in the business and it’s long run returns look better?

And if you picked badly how do you recognise this? If you are a value investor a la Mr Buffett you’re supposed to ignore the price falling and just buy more … but what if the fundamentals in the industry have changed (like Mr Buffett you quite like the newspaper industry but increasingly everyone is getting their news for free online)?

Add to this the well known predilection that people have for finding it hard to cut their losses and finding it equally hard to let their profits run, rather than take them too quickly, and it is easy to understand why so many private investors (and fund managers!) end up portfolios full of dogs. It’s not that they can’t recognise value when they see it: it’s that they can’t recognise when they’re wrong, and equally they don’t know when to sell when they’re right…

The great advantage of tracker funds is that they make these buying and selling decisions for you without your emotions coming into it (and without your time being spent on constant re-evaluation of your picks).